Re:Balance -- Jim Peterson

The Endangered State of EY's Split-Up Strategy

As I am pleased to discuss today as a guest on Francine McKenna's substack, The Dig -- whether or not EY actually does split, there are big implications for capital markets and professional service providers.

 

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Nine months on since last May’s revelation of EY’s plans to break up its audit and consulting practices into AssureCo and NewCo, freshly reported opposition from its US leadership has thrown the entire project into disarray.

Ernst & Young has paused its plan to spin off its consulting arm, bowing to pressure from its U.S. partners to rethink how the tax practice will be divided when the firm is split into two, according to people familiar with the matter.

As I put it in August, global CEO Carmine Di Sibio’s Project Everest looks increasingly to be “a hill too steep to climb.”

Allocation of the firm’s tax practices is said to be the sticking point, with the Financial Times reporting “‘chaos’, ‘low morale’ and ‘infighting’ at the firm,” while both deal details and the necessary country-level partner voting have continued to slide. 

As fully unpicked in this weekend’s Financial Times, outstanding uncertainties include:

• Resolution as to which of the 150-plus country practices and who among the thousands of employees will participate.

• Resolving whether to cut retired partners into the expected pay-outs.

• Allocation of legal liabilities, notably for the overhanging large litigations.

• Reduced value for the mooted IPO of a newly-created consulting enterprise.

• Fundamental challenges to raise necessary capital and achieve handsomely-projected growth rates.

• Persuading both existing and prospective clients of the ability of the bifurcated businesses to be competitive for value and quality.      

Large-country partner votes have slipped from last November, reportedly to April, but with the latest news suggesting they are now delayed indefinitely. NewCo’s IPO still aspires for late this year or perhaps now into 2024.

It’s an understatement that grounds for skepticism about Project Everest persist. Irrespective, there remains a serious concern -- namely, the very stability of Big Audit itself — the franchise by which the four networks that survived the collapse of Arthur Andersen in 2002 emerged to dominate the provision of audits for the world’s largest public companies.

Whatever its outcome, succeed or fail, the very launch of Project Everest has put EY’s structure and stability in play. Either way, that presents an existential threat to Big Audit, under the inevitable degrading of EY’s capability, because the survival of the Big Audit model itself depends on the continued health of the entire quartet of providers. Its number cannot realistically be reduced below its current critical limit. 

Suppose the Proposal Fails

For whichever among the lengthy list of possible reasons, there will be an inevitable burst of snarky criticisms. There will be time enough to savor the business school case studies written about a deal conceived in weakness and bungled in execution. Rather, if the audit partners were forced to remain in hostile cohabitation with the disappointed consultants whose lofty NewCo aspirations failed to materialize, consider the state of AssureCo’s internal morale, mutuality of commitment, and operational dislocations.

Carmine Di Sibio’s days would be numbered. He and his team would be fatally wounded as leaders, and the replacement process would be immediate. At best an uneasy peace might hold, while the process unfolds.

With the deflation of their rainbow-tinged expectations, the consultants would be disgruntled. Many would be inspired to pursue smaller, achievable niche transactions, and it would be open season for poaching. (The Financial Times report that PwC has a target of up to 500 EY partners in the US reflects the atmosphere; Alvarez & Marsal has announced its appetite and has already picked up a large practice group from EY China.) 

On top of the need to massage uneasy clients, the environment in the audit practice would be fraught. The energy sucked away by Everest — at a cost reported by the FT “set to rise to about $2.5bn by completion even before banks such as Goldman Sachs and JPMorgan take their fees” — means that engagement teams would re-assume their battle stations under extended stresses of time and budget.

Audit teams would be obliged to reach out to their consulting brethren as in the past, for the ancillary expertise necessary to do complex audits. But strained relations and inefficiencies would be predictable, especially if a critical mass of consultants were primarily aiming to negotiate the best achievable departure terms.   

Recruiting would be challenged. On the massive numbers, the firm’s announced hiring spree may either simply reflect that the Big Four continue to be employers of first resort for whole battalions of entry-level cannon fodder, or cover for predicted levels of turn-over, or more ominously, a whistle past a dark and uncertain graveyard.

As for retaining both staff and targeted veterans at the partner and manager level (see Bloomberg’s Amanda Iacone on February 15),  there would be limited attraction in an offer to join or remain with an enterprise where career aspirations go to die.

Suppose the Deal Succeeds

Suppose Di Sibio does achieve his plan to lead EY’s consultants toward a promised land of unconstrained opportunities and munificent rewards. He'd take with him as many A-players as the negotiations would tolerate from among the experts in tax, valuation, cyber security, blockchain, crypto, and all else under the broad heading of Sustainability.

Future events would determine both whether optimistic sources of public or private capital will splash out to enable the much-touted paydays, and whether a newly free-standing consultancy might rocket to success as the next Accenture, or achieve mediocrity in a crowded and competitive field.

That’s a matter of indifference to the capital markets, whose concern must be for the future of AssureCo.

Left behind in that legacy practice would be a rump of tax and other resources, staffed by those either uninterested, unwilling, or uninvited to join the exodus in search of greener pastures. AssureCo as a critical player in Big Audit would find itself challenged to retain, hire, or engage from the outside the resources needed to serve its book of large-company audit clients. 

A key challenge would be the simple one of execution, which has two parts.

The first is in carrying out large-company audits, where audit teams rely of necessity on their colleagues’ ancillary expertise. Consultants at NewCo would not be eager to be re-engaged as audit support, having forsaken EY’s network structure precisely to avoid the constraints of audit. Nor would third-party providers be in ready supply — having no more appetite to limit themselves under the rules of independence and practice limitations that they presently avoid.

And while a part of the pro-split messaging has been that AssureCo would set out to rebuild, replace and grow the practices departed to NewCo, the logic breaks down. That’s because the building of any new non-audit practice would confront the same limitations that are now driving Project Everest. That is, all those who believe that a successful consulting practice is incompatible with auditors would either have exited a combined practice in the first place or would shun a re-building effort in the second.

As for additional factors affecting what must be an atmosphere of uncertainty for EY’s audit partners, there are several.

Those of a certain seniority will be weighing their readiness to hand-hold a portfolio of uneasy clients, against the personal appeal of promptly cashing out whatever incentive payments emerge from the deal and heading for the retirement door. Non-competes, lock-ups and clawback provisions would be only reluctantly enforced — the morale impact of keeping an older cohort “retired in place” would be too gloomy to contemplate.  

The legacy firm will presumably be negotiating to retain the assets and liabilities appropriate to its practice — relevant if relatively inconsequential interests in real estate, methodologies and intellectual property, together with properly identified pension commitments and funding obligations.

But under an estimated reduction in global revenue from $45 to $18 billion, AssureCo would confront its future litigation and law enforcement exposures in a seriously weakened condition. In raw terms, its on-going capital structure and liquidity would have been severely eroded in the negotiations to deconstruct the EY global balance sheet.

Nor is there any reason to think that the departing consultants might agree to a “golden good-bye” adequate to satisfy EY’s current overhang of audit-related litigation, much less to assume any responsibility for the inevitable future outbreaks. For one specific, a matter of current attention and likely contention would be EY’s captive insurance program — a “cookie jar” funded by the willingness of the partners to make sacrifices in their current earnings, and not likely to be surrendered gratuitously by those departing.    

To conclude, the 17^th century French storyteller Jean de LaFontaine put the caution against hubris and over-confidence:

“Ne pas vendre la peau de l’ours avant de l’avoir tué.”

“Don’t sell the bearskin before you’ve killed the bear.”

The Americans’ opposition will not be the end of it. The mischievous energy of disruption has been released, and will not be tamed easily or without consequences.  

 

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Dispatch from the UK: KPMG Settles Carillion –- Whiners Are Not Happy

Guest posted today on Francine McKenna's Substack, The Dig -- a pleasure as always.

 

KPMG has settled the £ 1.3 bn claim brought against it by the liquidators of its client Carillion, the UK outsourcing behemoth whose spectacular collapse in January 2018 triggered an outpouring of the too-familiar criticism, “Where were the auditors?”

Five years on, the entire sorry story is playing yet again to the same tired script.

When the long-anticipated claim was officially commenced, in February 2022, the reaction from KPMG’s leadership was the usual attempted bravado and blame-shifting:  

“We believe this claim is without merit and we will robustly defend the case. Responsibility for the failure of Carillion lies solely with the company’s board and management, who set the strategy and ran the business.”

Now has followed the latest and fully predictable statement of capitulation, from UK CEO John Holt on February 13, 2023 --- which could have been drafted in 2018 and sealed in an envelope marked “Open when needed”: 

“I am pleased that we have been able to resolve this claim. Carillion was an extreme and serious corporate failure, and it is important that we all learn the lessons from its collapse.”     

For want of Mr. Holt’s specification of those “lessons,” let us ask what has been learned –- if anything?

To start, what is not disclosed for the public’s learning is the amount of KPMG’s exit price –- the UK firm using the frequent American tactic of costuming its settlement in a shroud of confidentiality (see the trustees’ claims against KPMG in New Century and against Deloitte in Taylor Bean & Whitaker, and MF Global / PwC).    

Next, depressingly, although there are surely specific lessons available from Carillion about improvements in the technical and complicated reporting, accounting and assurance for large, long-term contracts, none have emerged to inform investors and the capital markets. Not least, that is because the accounting profession has never developed a common forum or other means by which such catastrophes can be put to expert analysis, to be shared for the benefit of all concerned, as is widely done across the business spectrum -- e.g., in aviation safety, structural engineering, medical care, and manufacturing processes.  

One thing we do learn is that the expedient Mr. Holt has reduced by one the number of pending litigation threats against the Big Four that, at their worst, are large enough to be life-threatening. That population now includes, at least, Wirecard in Germany and NMC Health in the UK for EY, and for PwC, Evergrande in China and Americanas in Brazil.

With that small comfort, we also are reminded –- not having needed to learn -– that despite the massive volumes of perfervid critical rhetoric, nothing has been done over the last five years to have any substantive impact on the actual operation of Big Audit, the model by which the Big Four audit all but one of the FTSE 100 and 87% of the FTSE 250.

What has been learned instead is that across the entire body of players, there is a complete lack of will to alter the model:

• The large firms themselves display no discomfort with the current structure of their franchise –- their single gesture having been ready agreement to “operational separation” -- the optically appealing if substantively negligible evolution of expanded disclosure of the organizational and operating distance between their assurance and consulting practices.

• The comprehensive and insightful report and recommendations of Sir Donald Brydon’s “Independent Review into the Quality and Effectiveness of Audit” (December 2019), which recognized the necessity of evolving the assurance model and the qualifications of its professionals, failed to achieve any traction but instead sank without a trace.

• The Financial Reporting Council as the UK’s audit regulator has been shifting its furniture around within what Sir John Kingman described in his December 2018 “Independent Review of the Financial Reporting Council” as its “ramshackle house.” But the prospects that Parliament will actually legislate to re-name and re-configure the FRC as a new Audit, Reporting and Governance Authority –- dead-on-arrival through the years of Boris Johnson and the weeks of Liz Truss –- show no signs of life in the early but distracted and pre-occupied government of Rishi Sunak. Meanwhile as long mooted, Jon Thompson, the FRC’s leader through these fallow years, has chosen to swap one poisoned chalice for another by taking the chair at troubled rail link HS2.

None of this has stopped the whiners, whose petulant voices are heard yet again:

• Annop Rehal of the Haines Watts audit firm (14^th in the UK table -- at £ 105 m in revenue, approximately 2% the size of leaders PwC and Deloitte): the “issue of negligence at the top of the market (is) caused by the lack of ‘real competitors to challenge them’.”

• Gavin Hayes of the Chartered Institute for Internal Auditors: “there is no doubt that there are fundamental issues around a lack of competition in the market.”

For this topic, what has not been learned, or at least is not acknowledged, is the sterility of the discussion on auditor choice and competition, as the advocates for enforced re-structuring of the Big Four’s market dominance have yet to face the reality that the smaller firms lack the capacity, scope of expertise, and risk tolerance to make achievable any such aspirations.

Instead, the complexity of large-company audit and the required range of skills and global presence defy the challenge to carve out for the small firms a portion of such engagements –- either by line of business or by geography, and whether on their own or by forced job-sharing. No assemblage of the firms below the Big Four, singly or in the aggregate, has the necessary capability:

• Performance evaluations by the regulator, and the mix of investigative and enforcement actions involving the smaller UK firms, both caution the prospect of degraded audit quality, should actions be taken to force those firms upon the FTSE-indexed environment.

• A significant reminder regarding audit quality, if needed, is that the case has never been seriously advanced –- much less established –- that “smaller is better.” To the contrary, flares of financial and corporate misfeasance are reported around the globe, all involving the smaller firms: the crypto fiasco of FTX, the Gupta companies in the UK, Lex Greensill’s far-flung structure of companies, and the Adani group in India.

Neither the accounting profession itself nor its hand-wringing critics are heard to advance the difficult if realistic and achievable actions by which to re-engineer a model for large-company assurance that is fit for future purpose. The necessary holistic discussion among all the players awaits.  

 

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